Dumb Money and Emerging Markets

Sometimes it takes investors a while to figure out that things have changed—and then it takes even longer for them to alter their behavior accordingly, writes MoneyShow editor-at-large Howard R. Gold, also ofThe Independent Agenda.

How many people bought technology stocks years after the Internet bust, hoping that Cisco Systems (CSCO) or JDS Uniphase (JDSU) would reclaim their former glory? They never did, of course.

The same thing is going on now with one of the few hot asset classes of the last decade: emerging market stocks.

Until the 2008-2009 crash, emerging markets were among the world’s top performers. These countries survived the Asian financial crisis and their economies boomed in the 2000s. China became a great economic power, Russia surged on higher oil prices, India was awakening from a long socialist sleep, and Brazil catapulted to the top of Latin America’s economic pecking order.

So, it would surprise many investors to learn that the much-maligned US stock market has outperformed the MSCI BRIC and emerging-markets indexes for the last three years.

In fact, US mutual fund investors pulled an astonishing $464.9 billion out of mutual funds focusing on US equities from 2007 to 2011, according to the Investment Company Institute. They stashed almost $800 billion into bond funds during that period, of course, but they also poured $73 billion into emerging-market equity funds.

Even in the first two months of 2012, US investors yanked $5.3 billion out of US equity funds and funneled $5.2 billion into emerging-market stock funds.

So, while US stocks were quietly recovering and outperforming, investors dumped them for an asset class that has lagged the entire time!

But individuals weren’t the only ones taking the sucker’s side of this bet. They have plenty of company among the so-called “smart money,” which more often than not behaves like the thundering herd.

John-Paul Smith, global emerging-market equity strategist at Deutsche Bank in London, told me he still has trouble persuading his US institutional clients not to invest in emerging markets, on which he’s been bearish for almost two years. (Scott is one of the few strategists in Wall Street and the City who knows how to pronounce and spell the word “sell.”)

“For the last 19 months I’ve preferred the US, and it’s been a huge outperformer,” he said in a phone interview, recalling that in 1999 he advised pension funds to sell US stocks and go heavier into emerging markets.

But, he continued, “we still see pent-up demand from US pension funds to increase allocation to emerging markets.”

Apparently pension fund consultants, looking in a rear-view mirror, have been recommending that institutions allocate more assets to emerging markets because of their past performance. And pension funds will follow them blindly, because nobody ever got fired for buying Petrobras (PBR), right?

Smith thinks pension funds are making a “huge misallocation of assets” that they will regret in two to three years. Because everything isn’t rosy for emerging markets, particularly the BRICs that stole all the headlines just a few years ago. The iShares MSCI BRIC Index (BKF) ETF trades below its 50- and 200-day moving averages, an ominous sign.

The biggest problem with emerging markets now, said Smith, is massive government involvement in the corporate sector, which he thinks is “much worse” than in developed markets. I hope some of you were sitting down when you read that.

“The influence of the state on returns for minority investors defines emerging equity markets,” he wrote in a report. “State influence will increasingly drive returns going forward as growth momentum fades.”